What's Actually Going On With Private Credit
Portfolio managers John Sheehan and Craig Manchuk from Osterweiss discuss the historical origins, rapid growth, and current stress points of the private credit market. They trace private credit from GE Capital and mezzanine finance through post-2008 regulatory changes that pushed lending outside banks, and analyze structural vulnerabilities now emerging, particularly in retail-facing fund structures. They argue the market is unlikely to cause a 2008-style systemic crisis but warn of significant dispersion in manager returns and potential credit crunches.
Summary
The episode features Tracy Alloway and Joe Weisenthal interviewing John Sheehan and Craig Manchuk, portfolio managers at Osterweiss Capital Management's Strategic Income Fund, a $5.8 billion unconstrained 40-act mutual fund that has operated since 2002. The conversation provides a comprehensive historical and structural analysis of the private credit market.
The hosts begin by noting that private credit is difficult to discuss without encountering either dismissive industry insiders or apocalyptic doomsayers, and they seek nuanced commentary. The guests provide historical context by tracing private credit's roots not to the post-2008 era as commonly assumed, but to earlier institutional lenders like GE Capital, which financed aircraft engines, rail cars, and medical equipment for decades. GE Capital trained generations of experienced lenders who later splintered into firms like Heller Financial, which pivoted into middle-market LBO financing. Other institutions like CIT and ILFC (owned by AIG) also played formative roles before regulators pushed risky lending out of systemically important financial institutions.
The guests explain the evolution from bank balance sheet lending to the high yield market (aided by Michael Milken), then to the leveraged loan market, and eventually to CLO securitization. Post-2008, regulators explicitly prevented banks from lending to companies with greater than six times leverage, creating a vacuum that private credit filled. Simultaneously, the zero interest rate environment created massive investor demand for yield, and private equity sponsors needed reliable financing partners who could move quickly and provide more leverage than banks were permitted to.
The conversation then addresses the structural difference between institutional private credit funds and newer retail-facing vehicles like non-traded BDCs. Institutional drawdown funds allow managers to call capital only when deals are found, minimizing cash drag. Retail-oriented funds, however, take in subscription money upfront, which must be deployed quickly or it drags on NAV. This pressure to deploy capital rapidly led to weaker underwriting standards, more aggressive leverage, and looser covenants. The guests note that the apparent NAV stability of private credit funds during the 2022 rate hike cycle was partly illusory because these funds were not marking their portfolios to market, making them look attractive relative to publicly traded fixed income funds that were declining.
On the topic of liquidity gates, the guests argue these are critical for preventing bank-run dynamics but acknowledge they only manage the liability side of the equation. If outflows continue, managers will be forced to sell their highest-quality assets first, leaving funds more leveraged and lower quality. They reference the commercial real estate interval fund experience post-SVB as a partial precedent, where gating helped funds survive a panic period.
The guests highlight a specific divergence between private credit and high yield in the technology and software lending space. Unlike physical assets with recoverable collateral, software companies offer little recovery value in bankruptcy. Private equity sponsors persuaded private credit lenders to extend large loans at high multiples — sometimes 16-17x EBITDA — by offering higher equity contributions (40% vs. the traditional 20%), and also introduced PIK (payment-in-kind) structures where interest accrues rather than being paid in cash, giving the investment a quasi-equity character.
On systemic risk, the guests argue that the liability structure of private credit funds is fundamentally different from that of 2008-era institutions, making a comparable systemic crisis unlikely. However, they predict significant dispersion in returns across managers, with newer, less experienced managers who rapidly scaled their assets being most vulnerable. They note that Wall Street analysts have floated 15% default rate scenarios for private credit, which they consider high but not impossible given the leverage levels and floating rate exposure of many vintage 2020-2021 LBOs that now face much higher interest costs. The Osterweiss fund itself has no current private credit exposure, having been priced out of deals by more aggressive lenders over time. They note that their high yield portfolio has actually improved in credit quality, with double-B rated bonds now approaching 60% of the market versus 35% historically, as riskier borrowers have shifted to private credit.
The hosts conclude by reflecting that at a macro level, private credit has become larger than the junk bond market and serves as a critical financing channel for many American companies. Any sustained stress in the asset class would constitute a meaningful credit crunch with real economic consequences, even absent a systemic financial crisis.
Key Insights
- The guests argue that private credit's roots trace back to GE Capital and firms like Heller Financial in the 1980s and 90s, which means it is far older than the post-2008 narrative suggests — most commentators overlook this history because fewer people in the industry remember it.
- Post-2008 bank regulations explicitly barred banks from lending to companies with greater than six times leverage, which the guests identify as the single most important regulatory driver that created the vacuum private credit filled.
- The guests explain that retail-facing private credit funds face a structural problem that institutional drawdown funds avoid: they take in subscription money upfront and must deploy it quickly or suffer NAV drag, which pressures managers into weaker underwriting decisions.
- The guests contend that the apparent NAV stability of private credit funds during the 2022 rate hike cycle was partly misleading, because unlike publicly traded bond funds, these vehicles were not marking their portfolios to market — creating false comfort among wealth managers and their clients.
- Sheehan and Manchuk argue that private equity sponsors persuaded private credit lenders to extend loans at 16-17x EBITDA multiples by offering higher equity contributions (40% vs. the traditional 20%) and PIK structures, which they describe as a form of lender overzealousness driven by competitive pressure.
- The guests warn that software company loans represent a specific vulnerability: unlike physical asset lending where collateral retains recovery value, an obsolete software business may have near-zero recovery value in bankruptcy, and AI disruption has accelerated this risk.
- On systemic risk, the guests argue that private credit is unlikely to produce a 2008-style crisis because its liability structure is fundamentally different from deposit-funded banks — losses will be realized slowly over time rather than in a sudden liquidity crisis — but they predict significant return dispersion between experienced and inexperienced managers.
- The guests note that their own high yield portfolio has actually improved in credit quality over time, with double-B rated bonds now approaching 60% of the market versus roughly 35% historically, because the riskiest borrowers have migrated to private credit rather than the public high yield market.
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